Well, 2016 was an eventful year in Europe. Despite the maelstrom caused by the UK "Brexit" vote, considerable work was done in continuing the implementation of the post-financial crisis regulatory agenda. New legislation that came into force included the Benchmark Regulation, which will have a significant impact on structured products. At the same time, there was a year's delay in the implementation of two critical pieces of legislation: MiFID II/MiFIR and, right up to the wire, the PRIIPs Regulation. We set out below some of the ongoing events and regulatory developments that will continue to shape the structured products market in Europe into 2017.
Brexit: On 23 June 2016, the UK voted in referendum to leave the European Union ("EU"). This outcome was generally a surprise to the financial markets and gave rise to immediate market volatility, particularly in relation to the pound, which fell heavily in value against the euro and dollar. The vote, however, has no immediate effect. The UK currently remains a member of the EU, and existing EU-derived laws and regulations continue to apply to the UK. To commence its exit from the EU, the UK government has to serve notice of its intention to leave under Article 50 of the EU Treaty. The UK then has two years to negotiate the terms of its exit with the EU. If no agreement is reached, then at the end of this period (assuming no extension is agreed), the UK will automatically leave the EU and its trading relationship with the EU will default to World Trade Organisation ("WTO") rules. The UK Prime Minister, Theresa May, has indicated her intention that the Article 50 notice be served by the end of March 2017. The UK Supreme Court is currently considering whether such notice can be served by the UK government under its Royal Prerogative or whether the approval of the UK Parliament is necessary. The Supreme Court's decision is expected in early 2017, but whatever the outcome, it is not expected to have a major impact on the timing of service of the Article 50 notice.
There is considerable uncertainty as to what the nature of the UK's relationship with the EU will be, following its exit. In particular, it is currently unclear the extent to which the UK will seek, and the terms on which it will be able to agree, access to the EU single market for goods and services. It is, however, likely that financial services firms authorised in the UK will no longer be able to take advantage of the MiFID5 "passport" and to the extent that a UK-regulated entity carries out financial services or activities in the EU, separate authorisation(s) may be necessary. It is possible that for certain services and activities, non-EU firms (including UK firms after Brexit) may be able to rely on "equivalence" provisions in MiFID II and other relevant EU legislation, which will avoid the need for a full authorisation in the EU. These provisions are, however, limited in scope for example the new MiFID II legislation does not provide for an equivalence regime in respect of investment business with retail clients.
To date, it does not appear that the Brexit vote has had a major impact on the structured products industry in the UK and the rest of the EU. Most of the impact so far has been felt through the market volatility and downward pressure on sterling caused by the outcome of the referendum. Although market participants will be looking closely at the ultimate outcome of the Brexit negotiations, it is worth noting that many structured products in Europe, particularly retail products, are sold within a single jurisdiction and the cross-border implications of Brexit may not be as acute for structured products as for the wider wholesale financial securities markets. That said, there is likely to be a significant impact for structured products that use a UCITS wrapper if the UCITS fund is located in the UK or managed by a UK entity. UCITS funds are required to be domiciled within the European Economic Area ("EEA") and to be managed by an entity also located in the EEA. Assuming, as seems likely, that the UK leaves the EEA as well as the EU, absent any specific agreement as part of the Brexit negotiations, new UCITS funds will no longer be able to be established in the UK or managed by a UK entity. The position as regards such funds already established or located in the UK at the time of Brexit is unclear.
PRIIPs: The regulation on key information documents ("KIDs") for packaged retail and insurance-based investment products ("PRIIPs") was to have become effective on 31 December 2016. However, due to a delay in finalising the Regulatory Technical Standards ("RTS") setting out the detailed requirements for preparation of the KID, the implementation date has now been delayed until 1 January 2018.
Under the PRIIPs Regulation, when a person is advising on or selling a PRIIP to retail investors, a pre-contract KID must be provided to the investor. The Regulation contains detailed requirements as to the form and content of the KID. The draft RTS were first published by the European Supervisory Authorities ("ESAs")6 in November 2015. They focused, in particular, on the presentation and content of the KID (including methodologies for calculating and presenting risks, rewards and costs), the review, revision and republication of KIDs, and the conditions for fulfilling the requirement to provide the KID in good time. Following a consultation process and workshop for market participants, the EU Commission adopted the RTS in June 2016 and proposed a draft delegated regulation to give effect to them. However, echoing the concerns raised by a number of market participants and trade associations, the EU Parliament subsequently raised a number of issues on the draft RTS including the methodology for the calculation of future performance scenarios and the lack of detailed guidance on how the required "comprehension alert" should be structured. It formally rejected the proposed delegated regulation in September 2016 and the EU Commission subsequently agreed to the delay in the implementation date.
In its revised timetable, the EU Commission has indicated that the ESAs should submit revised RTS to it by the end of 2016 with a view to them being finalised within the first half of 2017. The EU Commission is also expected to issue further guidance on aspects of the PRIIPs Regulation and the RTS during the first half of 2017 in the form of Q&A. Although many market participants were well advanced in preparing their KID templates, the delay is generally welcome in the market. In particular, manufacturers of complex products were concerned with the prospect of the PRIIPs Regulation becoming effective without detailed guidance as to the contents of the KID. The delay will give product manufacturers more time to consider fully whether and how the requirements, in respect of the KID, can be applied in respect of certain products.
Benchmark Regulation: The use of benchmarks in financial transactions has been in focus in recent years, following alleged misconduct in relation to the setting of LIBOR and other financial indebtedness. In July 2013, the International Organisation of Securities Commissions ("IOSCO") published principles for financial benchmarks, and later that year, the European Commission published a draft regulation in relation to indices used as benchmarks in financial contracts, with the aim of reducing the risk of manipulation by ensuring that benchmark providers in the EU have prior authorisation and are subject to supervision. The subsequent legislative process was lengthy and involved significant amendments to the initial draft. The final regulation (the "Benchmark Regulation") came into force on 30 June 2016, although most of its provisions will not become effective until January 2018.
The Benchmark Regulation takes a different approach from existing benchmark regulation in a number of jurisdictions (including the UK), which has focused principally on widely used benchmarks. Instead, the Benchmark Regulation will apply to a very wide range of indices, including proprietary indices, which are used as benchmarks in a wider range of financial instruments or investment funds. The Regulation requires administrators of benchmarks that are located in the EU to be authorised or registered by their relevant competent authority. Such benchmark administrators are subject to a number of obligations, including governance requirements, oversight function obligations and record-keeping. Additional requirements apply to administrators of commodity and interest rate benchmarks. Benchmarks that are regarded as "critical" (determined by specified criteria, including that the benchmark is used as a reference for financial instruments having a total value of at least 500 billion) are subject to additional requirements, particularly where the administrator of such benchmark intends to cease to provide such benchmark.
The Benchmark Regulation is particularly significant for structured products sold in the EU, as a supervised entity will only be permitted to "use" a benchmark in the EU (which includes the issuance of a financial instrument referencing a benchmark or determining the amount payable under a financial instrument or contract by reference to a benchmark) if it is provided by an administrator authorised or registered under the Benchmark Regulation. For administrators located outside of the EU, the Regulation provides various routes under which they can come within the scope of the Regulation. This will generally require the administrator to be authorised in a jurisdiction with equivalent regulation or to comply with the vast majority of the provisions of the Benchmark Regulation.
ESMA has published a Consultation Paper on draft RTS which provide further detail on certain aspects of the Benchmark Regulation, including the circumstances in which an index will be regarded as having been made available to the public. It is expected that the final version of the RTS will be submitted to the EU Commission by April 2017 with a view to being finalised well in advance of the 1 January 2018 implementation date.
EMIR: The European Market Infrastructure Regulation ("EMIR"), providing for the regulation of derivatives in the EU, has been in force since 2012. However, much of the relevant rule-making under EMIR needs to be introduced by technical standards through delegated legislation. Although this process is well under way, some aspects of EMIR are still in the process of being introduced and this will continue into 2017 and beyond.
One of the central limbs of EMIR is the requirement for mandatory central clearing for derivatives entered into by financial counterparties and certain significant non-financial counterparties ("NFCs+"), subject to ESMA mandating that a particular class of derivative should be subject to such requirement. From June 2016, Category 1 counterparties (clearing members of at least one EU authorised CCP) have been subject to the obligation in respect of OTC basis swaps and vanilla fixed to floating swaps denominated in euro, pounds sterling, Japanese yen, and U.S. dollars and forward rate agreements and overnight interest swaps denominated in euro, pounds sterling and U.S. dollars. Category 2 counterparties (other financial counterparties or alternative investment funds ("AIFs") with outstanding trades with a gross notional amount exceeding EUR8bn) will be subject to mandatory clearing in respect of such transactions from 21 December 2016 and Category 3 counterparties (other financial counterparties or AIFs) will be subject to the obligation from 21 June 2017.
In addition, mandatory clearing will apply from 9 February 2017, for Category 1 counterparties in respect of (i) fixed to floating rate interest rate swaps and forward rate agreements denominated in Norwegian krone, Swedish krona and Polish zloty; and (ii) untranched index CDS referencing the iTraxx Main and ITraxx Crossover indices with a tenor of five years. Category 2 counterparties will be subject to mandatory clearing in respect of such transactions from 9 August 2017 and Category 3 counterparties from 9 February 2018.
The other significant area of development under EMIR during 2016 has been in respect of the margining requirements for OTC derivatives transactions, which are not subject to central clearing. EMIR requires certain counterparties to exchange collateral as a way of reducing counterparty risk exposure. Following a somewhat protracted process, the EU Commission adopted a final draft text of relevant RTS (the "Risk Mitigation RTS") on 4 October 2016.
The Risk Mitigation RTS primarily affects financial counterparties and NFCs+ that are established in the EU. However, non-EU entities that trade with EU entities that are subject to the margin requirements are likely to be obliged to put collateralisation procedures in place in order to allow their EU-established counterparties to comply with EMIR. The Risk Mitigation RTS require the posting of Initial Margin ("IM") and Variation Margin ("VM"). Such RTS also set out the eligibility criteria for assets that may be used as collateral, designed to ensure that the collateral is sufficiently liquid, not exposed to excessive credit, market or FX risk and holds its value during times of financial stress.
Collateral collected as IM must be segregated from the other assets of the third party or custodian that is holding it. Counterparties that collect IM are forbidden from re-hypothecating, re-pledging or otherwise re-using the collateral. There are some exemptions from the collateral requirements for transactions below certain financial thresholds and intragroup transactions complying with specified criteria. It is now expected that the Risk Mitigation RTS will come into force around January 2017. However, only the largest market participants (those trading non-centrally cleared derivatives in excess of 3trn in aggregate notional amount) will initially be subject to the rules. By September 2020, all counterparties trading such derivatives in excess of 8bn will be subject to the requirements.
MiFID II: MiFID II is the overhaul of the Markets in Financial Instruments Directive ("MiFID") and comprises a Regulation ("MiFIR") and a recast Directive. It came into force in August 2014 and was originally due to become effective on 1 January 2017. However, due principally to delays in drafting and finalising a number of the many RTS required to be prepared under MiFID II, legislation was adopted in July 2016 delaying the implementation date of MiFID II for a year until 3 January 2018.
MiFID II will make some fundamental changes to MiFID, including significantly widening the regulatory capture for both financial products and entities within the EU. A number of the proposed changes have particular relevance for structured products, including new product governance rules which will require manufacturers of financial instruments to undertake a product approval process for each product and ensure that each product is designed to meet the needs of an identified target market. Distributors must have arrangements in place to obtain relevant information for products they have not manufactured and to understand the characteristics and identified target market of products they distribute. Rules in relation to inducements now severely limit the circumstances in which firms can pay or be paid fees or commissions by any party other than their client. MiFID II also extends the pre- and post-trade transparency requirements to bonds, structured finance instruments and derivatives traded on a traded venue, although competent authorities can grant waivers in respect of such requirements on specified grounds, including in relation to instruments for which there is not a liquid market.
Many of the relevant technical standards under MiFID II have now been finalised and adopted. Much of the focus during 2017 will be on competent authorities in member states ensuring that they are in a position to ensure compliance with MiFID II from 2018. In the UK, the FCA is currently consulting on the UK implementation of MiFID II, with a deadline for comments of 4 January 2017. The FCA is then expected to publish policy statements on all aspects of MiFID II implementation in the first half of 2017. Member states are required to have transposed MiFID II into national laws by 3 July 2017.
Prospectus Directive (PD3): As part of its Capital Markets Union action plan, on 30 November 2015, the European Commission proposed a number of adjustments to the rules governing fundraising on public markets or through offers to the public, in the form of a Regulation (referred to as "PD3") that will replace the current Prospectus Directive. Proposed amendments include abolishing the existing "wholesale exemption" for debt securities (not listed on a regulated market) with a denomination of 100,000 or more, the creation of a lighter-touch disclosure regime for SMEs, a reduction in the length of prospectus summaries (and a harmonisation of such summaries with the KID required under the PRIIPs Regulation), fast-tracking and simplification for frequent issuers via use of a "Universal Registration Document" (similar to a shelf registration concept) and creation of a single access point for all EU prospectuses, making them more available and accessible for investors. It also contains new provisions relating to risk factors including requiring these to be allocated across two or three categories based on materiality and for the summary to include a summary of the principal risk factors (to be no more than ten). This could give rise to increased liability concerns, particularly in relation to structured products where categorising and limiting risk factors may be challenging.
It was originally expected that the new PD3 Regulation would be finalised during 2016. Progress has, however, been slower than expected. In September 2016, the European Parliament adopted a number of proposed amendments to the Regulation. The process will therefore continue into 2017, but we understand political agreement has now been reached between the EU Commission, the EU Parliament, and the EU Council of Ministers and it is expected that the Regulation will be finalised early in 2017.